Private equity is like wine - you have to look at the vintage

Private equity is like wine - you have to look at the vintage

Investing in private equity has been a popular alternative to listed equity investments for years. Investors who have decided to invest in private equity, will next have to deal with questions of allocation and the practical implementation.

The stock markets have changed dramatically over the past 20 years: For example, the number of listed US companies has decreased massively over time. These markets are mainly dominated by long-existing, mostly large, mature and slow-growing companies. At the same time, companies today remain in private hands for longer. These structural changes offer private equity investors good investment opportunities.

Better access to innovative companies

Private companies do not necessarily have to be listed on the stock exchange in order to access fresh capital. This means that companies remain in private hands for longer. At the same time, it is true that a later IPO can lead to bigger profits. This in turn leads to better access to young, innovative and high-growth companies on the stock markets. An ideal time to start investing in private equity.

Long horizon and strategic planning

Private equity investments have a duration of ten to twelve years and are suitable for investors with a long-term investment strategy. Since it is almost impossible to predict market conditions years in advance, it is extremely difficult to find a perfect timing for an entry. A strategy is needed to ensure that the initially fixed amount remains constant during this investment period and beyond such a life cycle. Private market investments follow a typical life cycle and the cash flow profile usually follows a J-curve.

Portfolio of promising corporate investments

The life cycle starts with a capital investment in private equity. The investment period begins once the capital has been committed. In this phase, the appointed private equity manager calls up the capital step by step and thus builds up a portfolio of promising corporate investments over a period of around six years. Investments, fees and expenses generate a negative cash flow. After company is acquired, the divestment is initiated according to the business plan (realization period).

The J-curve effect

As the portfolio matures, capital repayments continually increase. In principle, returns are paid out to investors rather than reinvested. After the end of the investment period, the investor receives only distributions, until the last company has been sold. This means that profits are generated by selling the investment. This results in a positive return and cash flow trend, the so-called J-curve effect.

The target allocation challenge

The market and the valuations cannot be predicted in the long-term and therefore, cannot be timed with any precision. To benefit from high and low valuations, it makes sense to plan and invest the allocation in private equity over several years, covering approximately seven to eight vintage years.

Optimal diversification of vintage years

As with wine, vintages can differ considerably. "Weak" vintage years result from high company valuations, because it is difficult to generate high profits from selling. At the same time, high valuations have a positive effect on the return on investments made in times of low valuations. Where investment groups are built up continuously, they achieve an optimal diversification of the vintage years: Investors should therefore invest in a new private equity scheme every two to three years.

Profound know-how is high in demand

Private market investments require solid know-how and many years of experience. In addition to knowledge of the various investment segments, investors also need to be versed in the regulatory and tax frameworks. Preference should be given to managers who pursue an active strategy aimed at improving companies and increasing their value, as well as ensuring a transparent and cost-effective structure.

Source:
B2B Schweizer Magazin für kollektive und strukturierte Investments, issue 64